Q: What types of risks do you encounter in the preferred stock asset class?
A: Our focus is on call risk, default risk and interest rate risk. These risks are the primary risks in all fixed income securities.
Q: Can you define call risk and tell us how it can be managed?
A: Most preferred stocks have a call provision that gives the issuing company the right to retire an issue at its discretion. The issuer may choose to do this if they can refinance the security at a lower cost. The provision specifies a call price and date when the issue becomes callable.
We monitor the preferred stock universe to identify issues that are callable and trading above call price. Those stocks are likely to have a negative yield-to-call (YTC) or yield-to worst (YTW). If we own one of those issues, we would look to sell it and use the sale proceeds to purchase another security more attractively priced on a YTW basis.
Q: Why would a callable issue trade above its call price?
A: Not all investors are focused on YTC. Many are simply looking for the highest current yields available. Those investors might be willing to take on the risk that the stock is not called in the near term so they are willing to pay a price above the call price (call risk). We don’t do that.
It’s also worth noting that index-based funds generally do not consider yield levels or yield-to-call levels. An index holds a list of index constituents, and reconstitutes the index based on a methodology. An index fund will then be required to hold a list of securities that are held in the underlying index. Purchases are generally made regardless of price, but rather when the index fund rebalances. We like to sell securities to funds that are not price sensitive, like the index funds.
Q: How do you manage default risk?
A: We don’t want to own distressed securities in our funds. When we see credit quality deteriorating, we perform a due diligence and generally become a seller of security that screens as distressed. Preferred stocks generally don’t fare well in bankruptcies so riskier securities should be avoided.
Q: How much flexibility do you have in managing interest rate risk? Without maturity dates, don’t preferred stocks have very long duration, like a long Treasury bond?
A: We believe this a common misconception. The effective duration of a preferred stock portfolio can be managed by shifting allocations among fixed-rate, fixed-to-floating rate and floating rate securities. There is a surprisingly a lot of flexibility.
Generally, when the rate structure is moving higher, floating-rate securities are the place to be. But high-coupon issues also provide some protection against rising rates. Low coupon issues are far more sensitive to rate swings. Rising rates also lead to upward adjustments in coupon rates of floating issues. We’ve seen a lot of interest rate movements in the last five years.
Q: Is there anything else that you would like to highlight?
A: Yes. I’d like to note that index-based preferred stock funds may own convertible preferreds with risk profiles more like common stock than preferred equity. We see some issues from technology and other industrial companies included in the indices. Those companies don’t look like typical preferred stock issuers. It is our view that investors should beware of the risks associated with holding these types of convertible preferred stocks in their funds. We actively manage our exposure to convertible preferred stocks in our funds.
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